What Is an ESOP and What Are Its Benefits?

Is an ESOP a Gift to Hard-Working, Loyal Employees?

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Employee stock ownership plans (or ESOPs) are a popular benefit that many companies offer to their employees. Owning a share of the company, without personal cost, is one of the many perks associated with long-term employment, and one of the reasons an employee chooses to join an organization. 

What is an ESOP?

An ESOP, or Employee Stock Ownership Plan, is a benefit or retirement-type plan for employees of a company.

  • Employees receive regular shares of the company’s stock as a benefit for working at the company.
  • All employees are eligible to participate in the ESOP after a certain period of time employed. Depending on the plan, ESOPs typically kick in about one to two years after an employee is hired.
  • The number of shares offered to each employee is determined by a formula set up by the company. This formula varies and could be based on pay-scale, the amount of time on the job, or similar factors.

A Gift to Employees

Most frequently, the ESOP is formed to provide an opportunity for the owners of a successful, closely held, private company to obtain liquidity for a portion of the shares that they own in the firm. In some cases, the ESOP allows the company to borrow money to purchase property or other assets (such as new equipment) using pre-tax dollars.

With ESOPs, the shares are priced conservatively based on the cash flow of the business, so it is a low valuation of the actual value of the firm. This makes the ESOP a gift from the shareholders to their employees. This is why you'll often hear the media announce the ESOP as saying that the employers 'gave the company to its employees.'

An Incentive for Good Performance

Another reason that businesses establish ESOPs is that it motivates and rewards employees in a meaningful way. After all, the hard work of a company's employees contributes significantly to the past and continued growth and success of the business. Smart business owners know this and want to keep employees happy. They also know that owning stock in the company is an incentive to remain at the company, which reduces employee turnover.​

The True Value of an ESOP

When you consider an ESOP from the point of view of the company owners, you must recognize that the company will be valued at a higher selling price by almost any other method that determines value.

For example, in most instances, selling the company would bring shareholders whatever the market will bear. This means that a successful company, sold to the highest bidder, could provide the owners with 20 times (or more) the valuation that is given for an ESOP.

This approach would cause disruption for the employees if the purchasing company, or individual, decided to move the business, merge the company with another business, or layoff redundant employees. In other words, the ESOP provides the greatest amount of stability for employees as long as the company remains successful.

What Happens to ESOPs at the End of Employment?

Most significant for employees, they receive shares in the ESOP without paying for them. When employees leave the company, either to work elsewhere or to retire, they receive their stock. The company is then required, in turn, to buy back the stock from the employee at fair market value.